Transcript Lecture Outline

“Taxes are the price we pay for civilization”
- 1927, Supreme Court Justice Oliver Wendell Holmes
Chapter 7
Taxation: Criteria for
evaluating revenue options
Lecture Outline:
 Overview of taxation in the United States
 Standards for tax policy
 Taxes and Externalities
Principles underlying taxation
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Private firms raise revenues through voluntary
exchange for goods and services with consumers
Ideally, taxes exist to provide services where the
private market is expected to fail to produce
these goods and services
Because of the incentive to free-ride when public
goods are produced, government uses coercive
payments (taxes) to collect revenues
Tax policy then distributes the cost of paying for
these goods and services across society
Government Revenue
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Sources of government revenue in the United
States income tax, purchase or sales tax, property
ownership or transfer
Revenues from charging for services (user fees,
etc.) and others sources (lotteries, interest on
investments, royalties, etc.) account for a small
percent of govt. funds
Special revenues, such as payroll tax on
employees for social security are allocated for
specific uses only
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Most economically advanced countries use a
general sales tax, US is unique in relying primarily
on an income tax
Taxation policies are a direct result of the political
organization of federalism (division of political
power and responsibilities among different units of
government)
Since sales tax has been the revenue source for
local governments, Federal govt. has had to look
elsewhere
Similarly, land property taxes would have
disproportionally burdened larger states at the
expense of smaller states
Thus the reliance is on “direct taxation”, taxation
on income rather than use of that income
Where does the US stand in terms
of taxation?
Compare the US rate of taxation to that of
other industrial counties (table 7-3)
 Generally, the tax burden is low when
compared to other nations. 28.9%
compared to average of 38.4% among
industrial nations. (Low of 16% with
Mexico, and High of 52% in Sweden).
 Ranks among bottom tier with Turkey,
Mexico, Korea and Japan
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US relies heavier on personal income and
corporate than most
 Heavier on property taxes
 And less on goods and services or sales
taxes
 About average in terms of amounts paid
toward social security
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Tax Policy Standards
Politics of taxation tends to be avoidance of
the cost, while complaining when not
receiving the benefit
 Public opinion alone (and indeed direct
democracy) would tend to produce very
inefficient policies
“Don’t tax you, don’t tax me, tax that fellow
behind the tree” (Sen. Russell Long)
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Where income tax dollars are spent
General taxation principles
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Since taxation removes funds from private decision-makers,
whose incentives to make purchasing decisions are directly
tied to the benefits they receive from those decisions (and
are therefore “efficient”), toward public decision-makers,
whose incentives are tied to broad organizational and
political goals unrelated to the goods and services the use
of those funds provide (and are therefore less “efficient”),
any taxation represents a burden on the private economy.
However without some taxation public goods and service
would not be provided
So the trick, is to design tax policies that gain revenue from
the private sector that do not unduly burden the economy
Four principles that guide taxation
in a market economy
1. Equity
2. Revenue consequences
3. Collection costs
4. Economic efficiency
1. Equity
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While logical to say taxes should be
distributed fairly, defining fairness of the tax
burden is rather difficult
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Do you think the tax system in this country is
fair?
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Write how you would define a “fair” taxation
system
Two general equity principles
 1)
Benefits Received - defined according to the
taxpayers’ benefits form or usage of a public
service
to Pay - defined according to taxpayers’
capacity to bear the burden
 2) Ability
Benefits received approach
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Benefits received approach mimics the private
market
The higher the payment the greater the benefit
When govt. sells a service, citizens pay a user fee
(ex: toll roads, gas tax to pay for roads, ammo tax to
pay for wildlife management)
Avoids wasteful over-production when goods are
produced at lower than market prices
Does not over-subsidize some goods at the expense
of other users
Avoids anti-tax sentiments
Problems with benefits received approach
Pure public goods do not provide an easy
way to match benefits with costs
 Does not allow re-distributive policies
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 Whether
redirecting funds from the wealth to
the disadvantaged
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Ex: CA Proposition 63
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in allowing equal access to nationally
produced benefits
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Ex: Determining the admittance costs to national
parks
Ability-to-pay approach
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Argues that regardless of service the greatest
burden should be placed on those who can most
easily bear the cost
Maintains that the types of goods provided by
govt. and the market are fundamentally different
and need to be supplied differently
Distribution of benefits should be provided by
concerns of equity and fairness
Problems with the ability-to-pay approach
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Difficult to determine actual individual level
demand without corresponding cost
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Over-supply of some types of goods
Horizontal and vertical equity
Horizontal refers to equal treatment of
taxpayers who have equal capability to
pay taxes
 Taxes may not be horizontally fair when
they vary by individual preference and
taste, or when one sector of the economy
has reduced tax burden (ex: fastfood tax,
tax breaks for high risk investors)
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Vertical equity
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Refers to the relative tax burden paid by
individuals with different capabilities to pay
taxes
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Question is how should tax payments
differ among high and low income earners
Tax structures can then be
categorized as:
Proportional – effective tax rates are the
same among all groups (10% across all
income levels)
 Progressive – higher rates are applied to
higher incomes
 Regressive – effective tax rates are higher
for lower income groups and lower for
higher income groups
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How much do Americans make?
US Income Pyramid
As Percent of Income
As Percent of Population
23.6 %
22.6 %
1.2 %
5.9 %
11.9 %
1%
5
10
20
Income
$ 719,000
$ 276,000
$ 188,000
$ 132,000
20 %
$ 53,000
22.5 %
20 %
$ 35,000
23.3 %
20 %
$ 21,000
22.7 %
20 %
$ 8,400
How much do Americans pay?
Who really pays?
The entity to which a tax burden has been
assigned, may be able to shift the tax
 The impact may not coincide with the
incidence because of tax shifting
 While law define the impact, market forces
determine the actual incidence
 Typically applies to business taxes
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Business replies to tax burdens
three ways:
1. Forward shifting: the business increases
prices to consumers
 2. Backward shifting: reduces the price
paid for resources purchased (wages to
employees and for raw materials)
 3. Absorption: returns a lower profit to its
owners
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Shifting has a similar impact
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Citizens are also consumers of goods and producers of
labor and material for producing those goods
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Individual consumers either they pay a higher purchase
price when business tax increases
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Or receive lower prices for the goods and services they
provided to business employers (labor, raw material,
etc.)
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All taxes are ultimately borne by individuals
If all taxes are ultimately paid by individuals,
then why tax businesses?
1. Politically more palatable
 2. Taxes can be designed to pay for costs
they produce to society but do not account
for in their decision-making
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Examples would include high consumption
of service (utilities, public safety, court
systems) & externalities (environmental
damage, pollution, undesirable social or
health effects)
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3. It is also less costly in terms of collection
Since additional costs will be shifted to
consumers, easier to tax the product a the
point of sale, than collect from individuals
after purchase (ex: luxury taxes)
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4. Finally, since all consumers will bear the
burden, it may shift tax paying
responsibilities to individual outside a
specific political jurisdiction
2. Revenue Consequences
Tax is only worthwhile if it produces revenues
at a socially acceptable rate
 Tax revenue equation:
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 Tax
yield (R) = Tax rate (t) times tax base (B)
R=t * B
 Simple linear relationship
 If total individual income is 200 million and tax rate
is 1%, then yield is 2 million.
 So if we increase the rate to 4% the yield is 4
million, right?
Economic impact of taxes on revenues
Linear relationship fails to include reaction to
taxpayer
 If increase tax burden, less incentive to earn
higher incomes and some taxpayers may
leave the taxing area
 Tax base will also be determined by the tax
rate
 So the effective tax base is R=t*B(t)
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Effect of economic growth on
revenue potential
As an economy grows, so do the demands
for government services (both at the micro
and macro level)
 Local economies need to provide more
infrastructure and utilities, law
enforcement and effective court systems,
and more demand for re-distributive
policies
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Some types of taxes are better able to
match revenue raising capabilities with
economic growth
 The relationship between a 1% change in
income to a population and the percent
change in revenue is expressed as
“elasticity”
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Tax-Income Elasticities
Personal income tax
 Corporate tax
 General property tax
 General sales tax
 Motor fuel tax
 Tobacco tax
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1.75
1.1
0.87
1.0
0.73
0.26
3. Collection costs
Costs of collection reduce the amount
available to use toward goods and
services
 Lower the complexity of a tax system, the
lower the cost of collection
 Tradeoffs exist between equity and
collection costs
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4. Economic Efficiency
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Taxes always have some effect on economic
efficiency, distort incentives and change
behavior
Creates a “tax wedge”, difference in before and
after tax price
Some argue that the best a tax can do is remain
neutral and impact the economy as little as
possible
Others maintain that taxes can be used to alter
incentives to produce favorable market
outcomes (such as reducing the generation of
externalities)
Types of activities taxed and their effects
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Work vs. leisure activities – high taxes on overtime will
reduce the incentive to work more and induce an incentive
to choose more leisure time
Business operations – firms will organize activities around
tax code. (Ex: inventory clearances).
Location – high taxes causes consumers to purchase those
items in neighboring areas (liquor, cigarettes, etc.). And
businesses to serve mobile consumers locate to gain those
customers.
Personal management – since professional conventions are
tax-deductible, most conferences tend to locate at resorts
Investment decisions – investments choices are made on
after-tax profits and may direct funds to different types of
projects (ex: toward municipal bonds)
Loss to an economy caused by a
tax can be minimized by:
1. Keeping tax rates low (have broad,
diverse tax systems)
 2. Avoiding different tax rates on similar
products
 3. Avoiding taxes in markets where buyers
and/or sellers react dramatically to
changes in price
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Local Taxes and Economic Development
State and local governments have
incentives to use tax policies to attract
investments for jobs and revenue
 Competition makes taxes critical policy
variable for impacting local development
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Questions regarding how much tax
policy really influences development
1. Taxes have a small effect on interregional
locations of economic activities. Total tax
burden is less important than the specific
burden for particular businesses.
 2. Within a region taxes have a larger effect
 3. Local govts. May offer additional
incentives: abatements, exemptions,
credits, etc.
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Importance of transparency
Because taxation in a democracy relies on
some basic level of public compliance, it is
important that people know what happens
to the taxes they pay
 The greater the transparency, the greater
the level of compliance and lower the
collection costs
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Elements of transparency
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Adoption
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Administration
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Compliance requirements
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Payment amount
Taxes and externalities
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Emission taxes
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Indirect taxes on goods and services